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Price Dynamics in the European Carbon Market

This paper examines the futures market contract constellation for Kyoto Phase II carbon financial instruments (CFI’s) as traded on the European Climate Exchange; the most sophisticated and liquid carbon exchange in the EU. The five December maturing futures contracts considered are officially known as European Union Allocations (EUA’s) and the period considered was a timespan from 22/05/2006 to 22/05/2008. The market was modelled using cointegration and Vector Error Correction (VECM) analysis and it was determined that the presence of a long run relation between the contracts indicated that the EUA futures market could theoretically be utilised as a risk mitigation tool through supporting the engagement of effective hedging strategies over time. The market did not, however, conform to a no-arbitrage cost of carry model, indicating that arbitrage opportunities could be prevalent in the market and that it may be inefficient. Analysis showed that the futures contract prices contained a significant element of convenience yield, which was negative and changing in magnitude over time. The negativity of the convenience yield is possibly indicative of a market perception that holding physical stocks of EUA’s is an undesirable activity. It was also determined that the futures market for EUA’s has evolved considerably since a structural break in April 2007 which roughly coincides with the price crash of Phase I EUA’s to €0.02 and a corresponding increase in trade volume of Phase II contracts. The market’s price discovery dynamics were investigated through weak exogeneity tests and Granger causality both in a bivariate and multivariate context, and it was determined that the body of evidence points toward the conclusion that the price discovery process is driven in tandem by the contracts at the extreme short and long ends of the maturity spectrum, in which the long end of the market may be dominant. These findings are in contrast to the accepted theory that in futures markets; spot prices should be the dominant driver of price discovery under a no-arbitrage condition, but is supportive to the contention that the EUA marketplace may exhibit segmentation delineated by participant preferred habitats of long or short maturity contracts